Main Street Capital Corp (MAIN) 2017 Q3 法說會逐字稿

Greetings and welcome to the Main Street Capital third quarter earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mark Roberson with Dennard Lascar Investor Relations. Thank you. You may begin.

Thank you, Jessie, and good morning, everyone. Thank you for joining us for Main Street Capital Corporation's Third Quarter 2017 Earnings Conference Call. Joining me on the call today are Chairman and CEO, Vince Foster; President and Chief Operating Officer, Dwayne Hyzak; and Chief Financial Officer, Brent Smith.

Main Street issued a press release yesterday afternoon that details the company's third quarter financial and operating results. This document is available on the Investor Relations section on the company's website at mainstcapital.com. A replay of today's call will be available beginning about an hour after the completion of the call and will remain available until November 10. Information on how to access the replay was included in yesterday's release.

We also advise you that this conference call is being broadcast live through the Internet and can be accessed on the company's homepage. Please note that information reported on this call speaks only as of today, November 3, 2017, and therefore, you're advised that time-sensitive information may no longer be accurate at the time of any replay listening or transcript reading.

Today's call will contain forward-looking statements. Many of these forward-looking statements can be identified by the use of words such as anticipates, believes, expects, intends, will, should, may or similar expressions. These statements are based on management's estimates, assumptions and projections as of the date of this call and there are no guarantees of future performance. Actual results may differ materially from the results expressed or implied in these statements as a result of risks, uncertainties and other factors, including, but not limited to, the factors set forth in the company's filings with the Securities and Exchange Commission, which can be found on the company's website or at SEC.gov. Main Street assumes no obligation to update any of these statements unless required by law.

During today's call, management will discuss non-GAAP financial measures, including distributable net investment income. Please refer to yesterday's press release for a reconciliation of these measures to the most directly comparable GAAP measure financial measures. Certain information discussed on this call, including information related to portfolio companies, was derived from third-party sources and has not been independently verified. And now, I'll turn the call over to Vince.

Thanks, Mark, and thank you all for joining us today. I'll comment on the performance of our investment portfolio, discuss our recent dividend increase and a few other recent developments and conclude by commenting on our investment pipeline. Following my comments, Dwayne Hyzak, our President, and Brent Smith, our CFO, will comment on our third quarter financial results, recent originations and exits, recent announcements, our current liquidity position and certain key portfolio statistics, and our operating expense ratio, after which we will take your questions.

We were very pleased with our third quarter operating results. Our lower middle market portfolio, our primary area of focus, appreciated by $9.1 million on a net basis during the quarter, with 19 of our investments appreciating during the quarter and 13 depreciating. Our middle market loans, private loans and our other assets collectively depreciated roughly $0.5 million during the quarter. We finished the quarter with a net asset value per share of $23.02, a sequential increase of $0.40 a share over the second quarter.

Our lower middle market companies collectively continue to exhibit very conservative leverage ratios on a relative basis, which Dwayne will cover in greater detail. Earlier this week, our board declared our first quarter 2018 regular monthly dividends of $0.19 a share in each of January, February and March of 2018, maintaining our fourth quarter monthly payout rate. The ex-dates for these dividends are December 28, January 18 and February 21, respectively. In addition, we're pleased to have recently announced our board's declaration of our semi-annual supplemental dividend to be paid in December of $0.275 a share. We expect to ask our board to declare a similar dividend to be paid next June.

Yesterday, we announced the appointment of Valerie Banner to our board. We are very excited to have a professional with Valerie's background become our 8th independent director. We have originated new lower middle market and private loan investments of roughly $410 million so far this year, which exceeds our budget for the full year. As of today, I would characterize our lower middle market investment pipeline, most of which if realized will likely close in the first quarter of 2018, is about average. We continue to seek and receive significant equity participation in our lower middle market investments, and as of quarter-end, we owned on average a 38% fully-diluted equity ownership position in the 99% of these investments in which we currently have equity exposure. Our officer director group has continued to be regular purchasers of our shares, investing approximately $0.5 million during the third quarter.

With that I'd like to turn the call over to Dwayne to cover our performance in more detail; I wanted to be particularly brief today to save room for potential tax reform discussion.

Thanks, Vince. Good morning, everyone. We're pleased to report another quarter during which we grew both our total investment income and distributable net investment income and again generated distributable net investment income in excess of our monthly dividends. Our third quarter operating results represent a GAAP return on equity, or ROE, of 12.7% for the trailing 12-month period and 10.7% on an annualized basis for the third quarter. Returns are in line with our stated long-term goal of producing an ROE percentage in the low to mid-teens.

We believe these results illustrate the significant benefits of our investment strategy of investing in both debt and equity in the lower middle market, which combined with our efficient operating structure and other complementary investment and asset management activities, continue to provide a value proposition that differentiates Main Street from other yield-oriented investment options and generates the premium total returns realized by our shareholders, as a result of the growth in our dividends per share, our net asset value per share and our stock price.

As we've discussed in prior quarters, we believe the primary driver of our long term success has been and continues to be our focus on the under-served lower middle market and specifically our investment strategy of investing in both debt and equity in the lower middle market and acting as a sponsor and a partner to the management teams of our lower middle market companies and not just a financing source. Without this primary focus on the lower middle market, it would be very difficult to produce these returns for our shareholders.

Given the unique benefits of our lower middle market strategy, for the past few years, we have been providing comments on different aspects of this strategy. Today, I'm going to discuss how we apply our long-term goal of generating a Main Street ROE percentage in the low to mid-teens when evaluating new lower middle market opportunities, and in the process, continue to generate net investment income in excess of our monthly dividends. We believe that some investors in BDCs have historically focused on monthly dividends only when evaluating their expected return. But as most people know, this approach could be highly misleading in situations where either the dividends are not covered by net investment income or when investment underwriting issues are causing the net asset value per share and therefore the stock price to decline over time. Instead of this dividend-focus approach, we believe that ROE is more important when setting goals and evaluating performance. When we evaluate new lower middle market investments, we focus on having the combined first lien debt and equity investments target a blended internal rate of return in the high-teens to low 20% range and a minimum current investment income contribution, which allows us to first maintain and then subsequently grow our monthly dividend to our shareholders.

From an underwriting standpoint, we achieved these targets by maintaining a disciplined mix of debt and equity investments with the typical initial investment comprised of approximately 75% to 80% debt and 20% to 25% equity and with very modest growth assumptions for this equity investment. We are confident that if we're successful in achieving this level of combined return and after taking into account our historical rate of performance issues and realized losses, and a very modest utilization of debt financing under Main Street's capital structure to fund these investments, that our lower middle market business will continue to allow us to deliver an overall Main Street ROE percentage in the low to mid-teens.

We also believe that our proven ability to generate this level of return, coupled with the large addressable market for lower middle market investments, is evident that the continued growth of our business through a combination of new equity issuance and modest debt capital issuance is in the best interests of our shareholders. As part of our ROE focus, we have also increased our focus on evaluating our existing lower middle market investments and executing on opportunities to exit investments, which are not positive contributors to ROE, so we can redeploy that capital into other investments. Partially because of these efforts, we have experienced moderately increased turnover activity in our lower middle market portfolio over the last several quarters and we expect this to continue in the future.

Now turning back to our most recent operating results. Consistent with prior quarters, the contributions from our lower middle market portfolio continue to be well diversified with 42 of our 70 lower middle market companies with equity investments having appreciation at quarter-end and with 27 of these companies that are flow-through entities for tax purposes, our 54% of our total investments these types of entities contributing to our dividend income over the last 12 months. In addition, we also have several equity investments in non-flow-through entities which have contributed to our dividend income. We believe that the diversity of our lower middle market portfolio is very important when analyzing the benefits from our lower middle market strategy, and we believe that this diversity provides visibility to the recurring nature of these benefits in the future.

We are pleased to report that our investment activity in the third quarter and our overall investment performance remain strong. Our investment activity in the third quarter included total investments in our lower middle market portfolio of approximately $45 million, including approximately $39 million in 1 new lower middle market portfolio company, which after aggregate repayments on debt investments and return of invested equity capital resulted in a net decrease in our lower middle market portfolio of approximately $11 million. We had a net decrease in our middle market portfolio of approximately $15 million and a net increase in our private loan portfolio of approximately $105 million.

As a result, at September 30, we had investments in 195 portfolio companies that are in more than 50 different industries across the lower middle market, middle market and private loan components of our investment portfolio. The largest portfolio company represents approximately 3% of our total investment income for the last 12 months and approximately 3% of our total portfolio fair value, with the majority of our portfolio investments representing less than 1% of our income and our assets.

Additional details on our investment portfolio at quarter end are included in the press release that we issued yesterday, but I'll touch on a few highlights. Our lower middle market portfolio included investments in 71 companies, representing approximately $938 million of fair value, which is approximately 17% above our cost basis. At the lower middle market portfolio level, the portfolio's median net senior debt to EBITDA ratio was a conservative 3.0 to 1 or 3.3 to 1 including portfolio company debt which is junior priority to our debt position. As a complement to our lower middle market portfolio, in our middle market portfolio, we had investments in 68 companies, representing approximately $607 million of fair value. And in our private loan portfolio, we had investments in 56 companies, representing approximately $486 million in fair value. The total investment portfolio at fair value at September 30 was approximately 106% of the related cost basis and we had 6 investments on non-accrual status, which comprised approximately 0.4% of the total investment portfolio fair value and 2.7% at cost.

In summary, Main Street's investment portfolio continues to perform at a high level and continues to deliver on our long-term goals. With that, I will turn the call over to Brent to cover our financial results, capital structure and liquidity position.

Thanks, Dwayne. We are pleased to report that our total investment income increased by 11% for the third quarter over the same period in 2016, to a total of $51.8 million, primarily driven by an increase in interest income of approximately $4.2 million, an increase in fee income of $0.6 million and an increase in dividend income of $0.4 million. The total investment income for the third quarter includes $1.7 million related dividend income that is considered either less consistent on a recurring basis or nonrecurring, which is consistent with the amount for the third quarter of 2016, and an increase of $0.4 million related to higher accelerated activity compared to the same period in 2016.

Third quarter 2017 operating expenses excluding noncash share-based compensation expense increased by $1.4 million over the third quarter of the prior year to a total of $15.3 million. The increase is primarily related to a $0.5 million increase in compensation expense, a $0.5 million increase in general and administrative costs, and a $0.8 million increase in interest expense. These increases were partially offset by an increase of $0.4 million in costs we allocated to the external investment manager for services provided to it. The ratio of our total operating expenses excluding interest expense as a percentage of our average total assets, which we believe is a key metric in evaluating our operating efficiency, was 1.5% on an annualized basis for the third quarter. Our increased total investment income and the continued leverage of our efficient operating structure resulted in a 12% increase in distributable net investment income for the third quarter of 2017 to a total of $36.5 million or $0.64 per share, which exceeded our recurring monthly dividends paid for the quarter by approximately 15%.

Our external investment manager's relationship with the HMS Income Fund benefited our net investment income by approximately $2.4 million in the third quarter of 2017 through a $1.7 million reduction of our operating costs -- operating expenses for costs we allocated to the external investment manager for services we provided to it and $0.7 million of dividend income from the external investment manager.

We recorded a net realized loss of $10.7 million during the third quarter, primarily relating to a net realized loss on the exit of a lower middle market investment. And as Vince discussed, we recorded net unrealized appreciation on the investment portfolio of $8.6 million in the third quarter, primarily relating to $9.1 million of net appreciation on our lower middle market portfolio, $1.6 million of net appreciation on our other portfolio, $2.2 million of appreciation on our external investment manager and $0.8 million of net appreciation on our private loan portfolio. This net unrealized appreciation was partially offset by $5.1 million of net unrealized depreciation on our middle market portfolio. Additional details for the change in our net unrealized appreciation can be found in our earnings release.

Our operating results for the third quarter of 2017 resulted in a net increase in net assets of $34.9 million or $0.61 per share. On the capital resources front, our liquidity and overall capitalization remain strong. At the end of the third quarter, we had $30.1 million of cash, $230 million of unused capacity under our credit facility, and approximately $75 million of incremental SBIC debenture capacity. Today, we have approximately $41 million of cash, $295 million of unused capacity on our credit facility, and $75 million of incremental SBIC debenture capacity.

We also continue to be pleased with the execution of our ATM equity issuance program. During the third quarter, we raised nearly $40 million in net proceeds, with an average sales price of $39.58 per share. As we look forward to the fourth quarter of 2017, we currently expect that we will generate distributable net investment income of $0.61 to $0.63 per share during the quarter. This estimate is $0.04 to $0.06 per share or 7% to 11% above our previously announced monthly dividends for the fourth quarter of $0.57 per share.

With that, I will now turn the call back over to the operator so we can take any questions.

(Operator Instructions) The first question is coming from the line of Robert Dodd with Raymond James.

Thanks, Vince, for bringing up with leaving extra time for the tax reform question. What's your view currently -- do you think on how that could, if it passes and impacts 2017, if it doesn't go to 2018 -- obviously, at your Analyst Day, you talked about it can have different -- obviously different impacts on dividend income versus NAV marks and fair value, et cetera. That's a really big question. But have you got any additional color that you can give us given where we are right now and it's on the Hill as we speak?

Yes. I spent quite a bit of time on since it came out, and I would say, overall, probably consistent with last summer, I would say modestly positive impact on our NAV, because the way we value our lower middle market equity investments we have -- we do a market approach and a DCF approach. And with respect to the DCF approach, you assume a C Corp buyer buys the company and then, in determining what they would pay, we've been assuming at 35% tax rate maybe plus [date], I don't remember. When you drop that to 20% that drives up the DCF component of your valuation as your companies are worth more to a C Corp buyer. On the other hand, your WACC would go up somewhat because your weighted average cost of capital has a 35% benefit on the interest expense component, which is no longer worth 35%, it is only worth 20%. So net-net, we were forecasting a low to mid-single digit increase in NAV attributable to the lower middle market valuation. So again, somewhat positive.

The next thing you look to, Robert, is the interest limitation. And we got to do a little bit more work on it, but generally it applies -- it's going to apply to everyone, flow-throughs and C-corps, et cetera. It's not going to apply interestingly, it looks like to REITs. And so we need to figure out if we're going to join the REITs in just having it not apply. But even if we did apply, it limits your net interest expense -- well, under the common understanding of net interest expense, BDCs would have more interest income than interest expense, so it shouldn't apply to us as a practical matter, even if we are carved out like the REITs. And it would be really surprising if somehow our interest expense was not viewed as trader business type interest expense to offset our interest income and therefore we have to worry about it.

With respect to our portfolio companies, first of all, there is an out if you have less than $25 million in revenue, and we have a lot of our companies that they're right in that range of $25 million in revenues, so we would actually do a deeper dive, but could be half our companies, it would have no application to at all. So assume you are in more than $25 million revenue company, your interest expense is limited to 30% of your EBITDA. So what does that mean? Well, if you have a company that you bought for 7x EBITDA that has $10 million in EBITDA, so you paid $70 million, and you levered it 4x with 8% debt, the company in year 1 would have $3.2 million of interest expense. The tax proposal would limit it to $3 million of interest expense, 30% times of $10 million in EBITDA. The [0.2] would be disallowed and carried over.

Again, it should be a fairly modest impact to most companies. Obviously you get 5x, 6x leverage and the EBITDA margins might not be as strong or what have you -- you can envision a situation where it could be more material, but -- so I think kind of at the end of the day, kind of a nonissue for us on the interest front. And then the final issue that we spent some time on is this 25% rate for active individuals in pass-throughs other than professional services pass-throughs. So most of our equity investments are in pass-throughs. And most of our, if not all of our, management members own equity and it is -- and they're not passive, right. And so our LLC agreements call for tax distributions equal to the highest marginal rate of any member of the LLC, which typically is going to be the individuals.

It will no longer be -- it will never be the blocker, because the blocker would have a 20% rate. So you look to the individual that would have the highest rate. And because the 25% rate on active pass-through income is limited to 30% of your income, when the smoke clears that roughly 40% federal rate manager of ours is only going to incur a 35% federal rate. And so you could see a modest decrease in tax-related dividends. And it gets a little bit more complicated than that, but again, basically immaterial for us. And that's the high level; that's probably all anyone wants to hear at this point. You can call me offline, if you want.

Okay, well, I mean all of that together, like -- because obviously that last part is the income to you. Most of the other frankly is potentially NAV, all of them bind together to ROE. But your view is this doesn't represent any -- raise any concern about having to change your ROE goals?

Correct. That's correct. Absent our first look at this, less than 25 hours, having missed something or misconstrued something. The plain meaning of it, it looks like it's more or less a non-event.

Just 1 final thing, on the Q4, the NOI guidance of $0.61 to $0.63 and you've said none of these changes will be particularly significant. Is that based on common tax status quo or a presumption that the new bill affects '17?

That is based on the current tax rules.

(Operator Instructions) Our next question is coming from the line of Doug Mewhirter with SunTrust Robinson Humphrey.

Thanks for heading off the inevitable tax question. I know that is your favorite subject in the world, Vince. Some nontax related questions, sort of hitting a couple of different topics. First, I may have transposed this in my brain when I read the report, but it appears that your middle market investments are marked below cost in aggregate. Again I may have reversed that, but that seems unusual given the fact that spreads have tightened so much. I just wondered if either I got it wrong or if there's anything behind that?

You got it right. And I would say that it's -- the reason it will be below cost, it is certain specific names as opposed to anything that's a market driven activity.

And then you combine that with -- in that portfolio, names won't trade above par really. And so the good performers are capped at par, and then also there's some underperformers that will be marked below par.

Your call protection where they can -- if they take you out, have to pay -- has to pay -- have to pay [101] for example, burns off after 6 to 12 months if you have it at all. And so it would be typically be constrained by being -- constrained at par in terms of valuation or in terms of how it trades, because you wouldn't want to pay par and a quarter and then get redeemed immediately or get called and you'd lose that quarter. So effectively you would expect this type of portfolio to trade below cost, because all it takes is 1 retailer or what have you, whose loans are trading at [90 or 95] or whatever it happens to be, and everything else trading at par, you would expect the portfolio to be marked under par.

Second, just any commentary on -- it looks like you had a pretty sizable jump in your private loan originations. I assume it's just a handful of deals and I assume nothing to read into that because I know it can be lumpy.

I'd say that activity, Doug, is consistent with what we've been saying now probably for the last year, if not longer. When you look at the different portfolios that we have between lower middle market, middle market and private loans, as you've heard us talk about for a long time, the lower middle market has been and always will be the primary focus. But if you look at the middle market versus the private loans, all things being equal, we would favor more activity in the private loan area. And we've been successful in building out that part of our investment strategy and practice over the last two years and we're seeing the benefits of that. And I would say that the benefits of that private loan strategy are particularly attractive given that the current activity over the last 6 months or so in the middle market which has gotten more aggressive from a pricing and term standpoint.

What's interesting about that market, Doug, is we don't have a dedicated private loan originated team -- originating team. So there are a lot of other lenders and all kinds of other individuals out there that -- we're emerging kind of as a preferred partner. We've been around, we have capital, they like the way we behave and we work as part of a group to try to be constructive. And so there is a lot of demand that's coming in that's unsolicited. Nick, would you describe it any differently?

I think the other thing to consider is some of the private loan portfolio would have been 2 or 3, 4 years ago considered middle market because they would have been led by a larger bank and now they're led by nonbank lenders. And so you've seen that disintermediation of the banks and can kind of move in more of our direction here on the nonbank side.

My last question, you still get that nice little kicker from your relationship with Hines' HMS growth. With the continued delays of the [DOR rule] -- and I also follow LPL, which is one of their largest distributors, and they've talked about how it's the pressure -- the regulatory pressure is not nearly as great as maybe people thought. Do you expect sort of a restart of the growth in the HMS Income Fund because of the less regulatory pressure? Or do you think brokers are still going to be really cautious just because they don't know what's around the corner?

Nick is on the board of HMS, so Nick, why don't you take that, your forecast?

Thanks, Vince. I'd say our thought on kind of a second vehicle with HMS will -- it's probably going to be a 2018 event on I'd say a significant scale. It's probably more of a 2019 time frame for us. We do think in talking to broker dealers out there, the LPLs of the world, there is an appetite for more products and they do want to place -- they want more BDCs or closed-end funds with yield. It's just trying to figure out the right structure that works for their investors and works for us as well. I think that's what the market is stuck with right now, is what is that structure and how you pay for it going forward.

And I want to clarify that HMS 1, that they have stopped fundraising as of early October.

As of September 30 was the final close on fundraising for HMS 1. And so any new kind of fundraising there will probably happen on a new vehicle.

There are no further questions at this time, so I'd like to pass the floor back over to management for any additional concluding comments.

Great. Well, again, thanks for joining us today and we look forward to talking to you next year. Bye.

Ladies and gentlemen, this does conclude today's teleconference. We thank you for your participation. You may disconnect your lines at this time and have a wonderful day.